Return preparer reliance on third-party tax advice

Editor: James W. Sansone, CPA

Tax return preparers are often asked to prepare tax returns that are consistent with tax positions or strategies that originate with third–party advice. Clients frequently receive services from attorneys, financial advisers, and other tax professionals in addition to their primary tax return preparer. Such advice can take the form of a formal written tax opinion, informal written or verbal advice, computational schedules, or even suggested reporting positions that lead to an entry on the client’s tax return.

Most tax return positions must be supported by substantial authority or reasonable basis with adequate disclosure to avoid accuracy–related penalties under Sec. 6662 if challenged. Sec. 6664(d)(3) provides that tax return positions involving reportable transactions must be adequately disclosed, identify substantial authority for the position, and have a good–faith belief that the position is more likely than not correct, to avoid accuracy–related penalties under Sec. 6662A (Sec. 6694(a)(2)(C)). The safeguards that protect taxpayers from accuracy–related penalties are the same safeguards that protect tax return preparers from preparer penalties under Sec. 6694. The potential for third–party advisers to reach different conclusions than the primary tax return preparer can create difficult professional practice dilemmas for the preparer tasked with signing the return.

Tax return preparers

Understanding who qualifies as a tax return preparer is the foundation for analyzing reliance issues. There are incongruities in the procedural requirements associated with the preparation of tax returns as a paid preparer. Sec. 6109(a)(4) and Regs. Sec. 1.6109–2(d) provide that after Dec. 31, 2010, all tax return preparers must have a preparer tax identification number (PTIN) in order to prepare tax returns for compensation. All federal tax–compliance forms for individuals, trusts, and business entities contain a field for the paid preparer’s PTIN next to the signature line.

A “tax return preparer” is defined in Regs. Sec. 301.7701–15(a) as any person who prepares for compensation all or a substantial portion of any return of tax or any claim for refund under the Internal Revenue Code (see also Regs. Sec. 1.6694–1(b)(5)). An individual or a firm that employs an individual is held to the same standards for assessing preparer penalties. For the purposes of this discussion, both are referred to as “tax return preparers.” A “signing tax return preparer” is the individual who has primary responsibility for the overall substantive accuracy of the preparation of such return or claim for refund (Regs. Sec. 301.7701–15(b)(1)). A “nonsigning tax return preparer” is any third–party adviser or tax return preparer who is not a signing tax return preparer who prepares all or a substantial portion of a tax return (Regs. Sec. 301.7701–15(b)(2)(i)). Examples of nonsigning preparers are third–party advisers who provide advice (written or oral) to a taxpayer (or to another tax return preparer) when that advice leads to a position or entry that constitutes a substantial portion of the tax return (see Regs. Sec. 301.7701–15(b)(2)(ii)).

The regulations list factors to consider in determining whether an item constitutes a substantial portion of the tax return, including the size and complexity of the item relative to the taxpayer’s gross income and the size of the understatement attributable to the item compared to the taxpayer’s reported tax liability (Regs. Sec. 301.7701–15(b)(3)(i)). A de minimis rule provides that amounts under $10,000, or less than $400,000 and also less than 20% of the gross income shown on the return (or, for an individual, the individual’s adjusted gross income), are not substantial (Regs. Sec. 301.7701–15(b)(3)(ii)(A)). This means that in practice, relatively modest planning work can constitute a substantial portion of a tax return.

Thus, there is ample opportunity for third–party advisers to rise to the level of nonsigning preparers with respect to the line item or entry they advanced on the tax return. However, there is no field on any federal tax form that requires the identification of the nonsigning tax return preparer through a PTIN or other reference. Instead, it remains the signing tax return preparer whose identity is disclosed and who retains responsibility for the overall substantive accuracy of a tax return or claim for refund. This puts the signing tax return preparer in a precarious position when a third–party adviser advances a position to be reported on the tax return that the signing tax return preparer has not evaluated, especially if the position may result in penalties.

Accuracy–related penalties under Sec. 6662 and practitioner penalties under Sec. 6694 both require substantial authority or a reasonable basis with adequate disclosure of any uncertain tax return position to avoid penalties. Adequate disclosure is achieved through the filing of Form 8275, Disclosure Statement; Form 8275–R, Regulation Disclosure Statement; or equivalent. Form 8275 is used to disclose positions that may be contrary to existing tax authorities that are not otherwise adequately disclosed on a tax return. Form 8275–R is used to disclose positions that are contrary to Treasury regulations. Circumstances under which the disclosure on a taxpayer’s income tax return with respect to an item or position is adequate for the purpose of reducing the understatement of income tax under Sec. 6662(d) and for the purpose of avoiding the tax return preparer penalty under Sec. 6694(a) with respect to income tax returns are outlined in a revenue procedure that is periodically updated, Rev. Proc. 2024–44 at the time of this publication.

A client may not give the signing tax return preparer a sufficient budget to fully vet third–party positions because it is unlikely that a client will pay two advisers for the same advice. How, then, can a signing tax return preparer be comfortable with third–party conclusions or determine if adequate disclosure is required to avoid penalties if the preparer does not have an opportunity to independently research and analyze the position?

Third-party reliance

Fortunately, Regs. Sec. 1.6694–1(e) and Section 10.37(b) of Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), permit tax return preparers to rely on third–party advice if the advice is reasonable and the reliance is in good faith, considering all the facts and circumstances. Reliance is not reasonable if:

• The practitioner knows or reasonably should know that the opinion of the other person should not be relied on;
• The practitioner knows or reasonably should know that the other person is not competent or lacks the necessary qualifications to provide the advice; or
• The practitioner knows or reasonably should know that the other person has a conflict of interest with respect to the advice given to the client.

In determining whether the above criteria are satisfied, Circular 230 provides that the IRS will apply a “reasonable practitioner” standard to evaluate whether reliance is reasonable (Circular 230, §10.37(c)(1)). The tax return preparer may not ignore the implications of information furnished to, or actually known by, the tax return preparer. The tax return preparer must make reasonable inquiries if the information furnished to the tax return preparer appears to be incorrect or incomplete. Some positions may require third parties to produce certain documents for reliance on a position to be reasonable (e.g., an appraisal may be required to support a charitable contribution deduction for certain types of property) (Regs. Sec. 1.6694–1(e)(1)). If reliance on third–party advice is reasonable and made in good faith, the signing tax return preparer can sign the return and assert a reasonable–cause defense against any preparer penalties if proposed (Sec. 6694(a)(3)).

Thus, it is important for signing tax return preparers to understand when reliance on third–party advice is unreasonable and the actions a preparer can take to avoid such outcomes.

The enforceability of Circular 230 was drawn into question by Ridgely v. Lew, 55 F. Supp. 3d 89 (D.D.C. 2014), which enjoined the IRS from imposing penalties on a preparer of “ordinary refund claims,” which may extend to all return preparation activities. However, the IRS has not revised or rescinded Circular 230, and preparer penalties for inappropriate reliance on third–party advice are still enforceable under Regs. Sec. 1.6694–1(e). Thus, the Circular 230 standards still inform signing tax return preparers on how to avoid preparer penalties.

Opinion of another person should not be relied on

A signing tax return preparer must gauge whether third–party advice has obvious defects for which it should not be relied upon. Such defects might include unreasonable assumptions, omission of material facts or analysis of negative authority, reliance on authority that is superseded or outdated, or inconsistencies with other positions included in the taxpayer’s filing history (see, e.g., Stobie Creek Investments, LLC, 82 Fed. Cl. 636 (2008), aff’d 608 F.3d 1366 (Fed. Cir. 2010) (reliance on law firm opinion for tax shelter rejected because opinion was based on misrepresented facts); see also Canal Corp., 135 T.C. 199 (2010) (Tax Court rejected reliance on a tax opinion “riddled with questionable conclusions and unreasonable assumptions” in reaching a “should” confidence level)). The signing tax return preparer should conduct reasonable diligence with respect to the facts and technical merits of the positions asserted. Following are some actions that preparers may wish to take in performing that diligence:

• Ask the client to confirm that facts described in the third-party advice are accurate and complete.
• Check all sources cited in third-party analyses to confirm that sources are real, on point, and are not “hallucinations” generated by artificial intelligence.
• Look for negative authority that might have been omitted from the analysis supporting the third party’s position.

It is common for attorney advisers to refuse access to their work product to preserve attorney–client privilege. In that case, a signing tax return preparer should request an acknowledgment from the authoring attorney that an opinion, memorandum, or other advice exists. The letter should describe the resulting position and indicate whether the preparer can sign the return with or without adequate disclosure to secure penalty protection. Be wary of any communication that attempts to disclaim responsibility as a nonsigning preparer. Preparer status is determined by the definitions in Treasury regulations, not by agreement between the parties. If the acknowledgment raises additional questions, the signing tax return preparer should interview the author of the advice to vet the author’s analysis supporting the position.

Less–than–satisfactory responses to any of the above inquiries should be discussed with the client and may serve as grounds for the tax return preparer to refuse to sign a tax return or claim for refund if the client insists on taking the reporting position.

Other person is not competent or lacks qualifications

A signing tax return preparer may not rely on advice given by third parties who lack appropriate credentials to provide such advice or from third parties who have been disciplined for providing improper tax advice. Many third–party tax advisers are CPAs, attorneys, or enrolled agents. Credentials for these professionals can be verified through state boards of accountancy, state bar associations, the National Association of State Boards of Accountancy, or the IRS Directory of Federal Tax Return Preparers. The IRS Office of Professional Responsibility maintains a list of sanctioned tax professionals that should also be searched.

The realm of adviser credentials that may be relevant to third–party advice is not confined to tax professionals. Certified financial planners, engineers, appraisers, and other professionals are often involved in providing third–party tax advice. Boutique advisory firms employing CPAs, attorneys, and enrolled agents but not necessarily practicing in those capacities also contribute to the development or marketing of tax positions. Subject matter expertise in almost any field can be relevant to certain tax questions. Irrespective of the individual’s discipline, a signing tax return preparer should always confirm that the third party advancing a tax return position has the appropriate credential or experience required to give advice and has not been discredited by disciplinary actions taken by any relevant oversight body.

Positions advanced by persons who lack the competency or qualifications to provide advice may be valid, but a signing preparer will have to independently research the position and arrive at his or her own level of confidence regarding the position if the preparer hopes to secure penalty protection.

Other person has a conflict of interest

A signing tax return preparer may not rely on the advice of a third party who has a conflict of interest with the underlying client. The most common conflict scenario involves third–party advisers who are paid a percentage of the tax benefits secured for the client. Contingent–fee arrangements may incentivize third–party advisers to take aggressive positions to maximize their fees. The IRS’s ability to police contingent–fee arrangements was also enjoined by Ridgely, but preparer penalties for inappropriate reliance on third–party advice are still permissible. The signing tax return preparer provides an important check on potentially abusive positions that could result in penalties assessed against the client.

Other conflicts may result from relationships between the client and the third–party adviser, such as the promoter of an investment opportunity that promises tax benefits to investors (see, e.g., Gustashaw, 696 F.3d 1124 (11th Cir. 2012) (taxpayer’s reliance on tax opinion found unreasonable in part because of conflicts of interest)).

Again, positions advanced by self–interested third parties may be valid, but signing preparers will have to conduct their own diligence with respect to the position if they hope to secure penalty protection.

Define roles and responsibilities of third-party advisers

Sophisticated clients often seek advice from a variety of professionals with respect to tax matters. It is inevitable that advisers will form different opinions with respect to the merits of certain tax return positions and the level of confidence assigned to such positions.

Signing tax return preparers have a unique responsibility in this crowded field of advisers. They are the only advisers ultimately responsible for the overall substantive accuracy of a tax return or claim for refund. When the signing preparer is asked to rely on third–party advice, clients need to be educated about the role of third–party advisers who become nonsigning tax return preparers and the conditions required for reliance on such advice to be deemed reasonable and made in good faith.

If a signing tax return preparer intends to rely on third–party advice, they should ask the third–party adviser to acknowledge that they are nonsigning preparers once the appropriate diligence is complete. It is much better to discuss the roles and responsibilities of all advisers at the front end of the tax–reporting process than to point fingers at each other if a controversy arises.

Contributors

Jeffrey Malo, J.D., LL.M., and Deanne B. Morton, J.D., LL.M., are managing directors, and Daniel Z. Nettles, J.D., is a director, all in Andersen Tax LLC’s U.S. National Tax Office. Leland Quinn, J.D., LL.M., is a manager in Andersen Tax LLC’s Seattle office. James W. Sansone, CPA, is managing director, Office of Risk Management, with RSM US LLP in Atlanta. For more information about this column, contact thetaxadviser@aicpa.org.